Will SEC Report on GameStop Stock Frenzy Lead to Regulatory Changes?

The SEC recently published its much-anticipated report on the January 2021 GameStop (GameStop or GME) stock trading frenzy and the larger meme-stock phenomenon...

The Securities and Exchange Commission (SEC) recently published its much-anticipated report on the January 2021 GameStop (GameStop or GME) stock trading frenzy and the larger meme-stock phenomenon. The report, entitled Staff Report on Equity and Options Market Structure Conditions in Early 2021, highlighted areas that need further examination but stopped short of calling for specific regulatory changes.

“The extreme volatility in meme stocks in January 2021 tested the capacity and resiliency of our securities markets in a way that few could have anticipated,” the report stated. “At the same time, the trading in meme stocks during this time highlighted an important feature of United States securities markets in the 21^st century: broad participation.” The report concludes: “These events present an opportunity to reflect on the market structure and regulatory framework and identify additional areas for potential study and further consideration in the interests of protecting investors, maintaining fair, orderly, and efficient markets, and facilitating capital formation.”

What Are Meme Stocks?

The SEC report addresses the recent phenomenon known as “meme stocks.” The term refers to stocks that gain sudden popularity on the internet, largely through social media and websites like Reddit. When stocks go “viral,” it generally causes prices to skyrocket and generates unusually high trading volume. In many cases, a meme stock’s increasing value reflects the social media buzz rather than the company’s performance, which can lead to a dramatic drop in stock price as it becomes overvalued.

GameStop Trading Frenzy

As highlighted by the SEC, GameStop experienced a confluence of all of the factors that impacted the meme stocks in early 2021, including: large price moves; large volume changes; large short interest; frequent Reddit mentions; and significant coverage in the mainstream media. As we detailed in prior articles, everyday investors united on social media to send GameStop Corp’s stock price soaring to astronomical levels, climbing a staggering 1600 percent in the month of January. The high-trading volume caused significant losses for hedge funds and other firms that bet the stock price of the struggling company would continue to fall. The market volatility also rattled Wall Street and ultimately caused online trading platform Robinhood to temporarily halt trading.

In the wake of the market volatility, Congress called Robinhood Chief Executive Vlad Tenev to testify. The SEC also launched its own investigation into whether any federal securities regulations were broken and whether additional regulations were needed.

SEC Report Offers Recommendations

The SEC report largely detailed how and why the meme stock episode occurred, concluding that a rapid increase in trading by individual investors largely fueled the frenzy. In doing so, the agency sought to debunk theories circulating on the Internet that a “short-squeeze” sent the stock price soaring. “Whether driven by a desire to squeeze short-sellers and thus to profit from the resultant rise in price, or by belief in the fundamentals of GameStop, it was the positive sentiment, not the buying-to-cover, that sustained the weeks-long price appreciation of GameStop stock,” the SEC wrote.

While the SEC report does not expressly call for specific regulatory changes, it does make several recommendations. Below are several issues that the agency flagged for further review:

• Forces that may cause a brokerage to restrict trading. The SEC report noted that during the GME episode a number of clearing brokers experienced intraday margin calls from a clearinghouse. In reaction, some broker-dealers decided to restrict trading in a limited number of individual stocks in a way that some investors may not have anticipated. According to the SEC, the episode highlights the integral role clearing plays in risk management for equity trading, but raises questions about the possible effects of acute margin calls on more thinly-capitalized broker-dealers and other means of reducing their risks. The SEC report goes on to state that one method to mitigate the systemic risk posed by such entities to the clearinghouse and other participants is to shorten the settlement cycle.
• Digital engagement practices and payment for order flow. The SEC report concludes that consideration should be given to whether game-like features and celebratory animations that are likely intended to create positive feedback from trading lead investors to trade more than they would otherwise. In addition, payment for order flow and the incentives it creates may cause broker-dealers to find novel ways to increase customer trading, including through the use of digital engagement practices.
• Trading in dark pools and through wholesalers. Much of the retail order flow in GME was purchased by wholesalers and executed off exchange, according to the SEC. Its report further highlights that such trading interest is less visible to the wider market—and payments to broker-dealers may raise questions about the execution quality investors receive. Further, though wholesalers increasingly handle individual investor order flow, they face fewer requirements concerning their operational transparency and resiliency as compared to exchanges or ATSs.
• Short selling and market dynamics. While short selling and calls on social media for short squeezes received a great deal of media attention, the interplay between shorting and price dynamics is more complex than these narratives would suggest, the report states. Going forward, the SEC suggests that improved reporting of short sales would allow regulators to better track these dynamics.

One of the issues most likely to attract further scrutiny is the “game-like” features used by trading apps. In August, the SEC formally requested information and public comment on matters related to the use of digital engagement practices (DEPs) by broker-dealers and investment advisers. “The request will facilitate the commission’s assessment of existing regulations and consideration of whether regulatory action may be needed to further the commission’s mission, including protecting investors,” the SEC said in a press statement.

If you have questions, please contact us

If you have any questions or if you would like to discuss the matter further, please contact me, Thomas Herndon, Jr., or the Scarinci Hollenbeck attorney with whom you work, at 201-896-4100.